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BUNDLES APPROACH
Centre for Business Research, University of Cambridge
Working Paper No. 438
by
Gerhard Schnyder
Kings College
London
Email: gerhard.schnyder@kcl.ac.uk
December 2012
This working paper forms part of the CBR research programme on Corporate
Governance
Abstract
This paper reviews recent studies that analyse and criticise existing academic
and commercial corporate governance (CG) indices. Most of these rating the
ratings papers reach the conclusion that encompassing composite measures of
CG are ineffective and suggest therefore to return to simpler measures. This
paper draws on the configurational- or bundles approach to CG and argues
that, while the criticisms made by the rating the ratings papers are justified,
their recommendations are misguided. Based on four central insights derived
from the bundles approach, the paper shows that reverting to simpler measures
of firm-level CG practices is a step in the wrong direction, in that it eliminates
information about interactions between different corporate governance
mechanisms. This is particularly consequential for comparative CG research
that aims to identify differences in country-specific CG systems. Alternative
solutions are developed to improve corporate governance measures, which take
into account insights from the bundles approach.
Further information about the Centre for Business Research can be found at the
following address: www.cbr.cam.ac.uk
1. Introduction
One of the major challenges of corporate governance (CG) research since its
inception has been the definition of measures of good corporate governance,
i.e. of corporate governance mechanisms that lead to financial efficiency, social
legitimacy or more generally goal attainment (cf. Judge 2010 for the two
former, Aguilera et al. 2008 for the latter).1 In order to analyse the impact that
CG has on different measures of corporate performance, academics and
commercial providers have either used individual variables (such as board
independence and ownership structure) or have attempted to construct
composite measures of corporate governance practices. Despite considerable
efforts and despite considerable sophistication of measures and methods, the
results so far are surprisingly ambiguous and contradictory (Bhaghat et al.
2008). In particular, it has proven very difficult to show that even sophisticated
professional measures of the quality of a companys corporate governance
system produced by different commercial providers are indeed able to predict
future performance.
This situation has led to a series of studies that review the existing rating
schemes and corporate governance indices (Bebchuk et al. 2009, Bhagat et al.
2008, Brown & Caylor 2006, Daines, Gow and Larcker 2010, Renders et al.
2010). The main finding of these rating the ratings papers is that composite
measures of CG practices are ineffective in so far as they do not predict
performance outcomes better than single measures. More worryingly, different
measures from different providers that purport to measure the same underlying
phenomenon (i.e. the quality of corporate governance) are only weakly
correlated with each other.
Some authors explain the weak evidence for a link between CG and
performance as a limitation of the methods used (cf. Renders et al. 2010).
Others, however, focus on a more fundamental problem regarding measurement
errors and index construction. Two criticisms can be distinguished within the
latter group: firstly, there is a lack of theoretical justifications for the
composition of these indicators (what to include and what not); secondly, a
convincing method or a theory to determine the weighting of different variables
included in the index is lacking.
This paper reviews the existing rating the ratings and related papers and
argues that while methodological efforts and innovations are laudable, they will
remain pointless as long as these new methodological approaches are applied to
fundamentally flawed measurements.2 Indeed, the weak correlation among
different ratings indicates that the problem is a fundamental one of defining and
measuring good governance, rather than a problem that can be solved
1
downstream, i.e. at the stage of data analysis (cf. Larcker et al. 2007). Rather
than further seeking to improve statistical methods, the focus should shift
towards the upstream problem of how we conceptualise and measure CG in
the first place (cf. Daines et al. 2010: 441).
One common suggestion derived from the observed limitations of composite
CG indices is to return to simpler measures of corporate governance in order to
avoid the problems associated with measurement errors and index construction
(Bhagat et al. 2008; Bebchuk et al. 2009).
Yet, this suggestion seems problematic in view of recent developments in the
CG literature. Different recent contributions (Aguilera et al. 2012 and 2008,
Ward et al. 2009) show that different CG mechanisms may appear ineffective if
investigated individually, but may have an important impact on outcomes in
combination with other CG mechanisms. Also, certain firm-level CG
mechanisms may have an impact on outcomes only in a given environment, i.e.
in combination with certain institutional factors (Kogut 2012, Aguilera et al.
2008, Filatotchev 2008). This has led to an increased attention to combinations-,
or bundles of corporate governance practices at the firm level and how they
may relate to different organisation-level and contextual contingencies. Based
on these insights, the claim that simpler measure of corporate governance at
firm level should be used appears like a step in the wrong direction. Even if a
single variable may strengthen the predictive power of a model, it seems likely
that using such a simple measure for the complex construct of corporate
governance will lead us to miss potentially important interactions between CG
mechanisms. This shortcoming is particularly important in comparative
research, because it leads us to neglect important functionally equivalent CG
mechanisms across countries and to overlook contextual contingencies.
Therefore, rather than reverting to simpler or even univariate measures of CG,
this paper constitutes an attempt to integrate insights from the bundles
approach to the question of index construction for comparative CG research.
Based on this discussion, an alternative approach to index construction is
developed.
The paper is structured as follows. Section 2 reviews the recent literature
criticising widely-used CG ratings and indices. Next I present recent insights
from the bundles approach to corporate governance. Section four provides
suggestions regarding the development of more meaningful comparative
measures of firm-level CG. Conclusions are drawn in the final section.
reliable way. For all dependent variables (DVs) that they use (accounting
restatements, shareholder litigation, operating performance, stock returns and
cost of debt) the predictive power of the four CG metrics are weak with some of
them even showing negative correlations, i.e. worse corporate governance
leads to better performance. 4 The most reliable measure appears to be the AGR,
which tellingly is different from the other ratings in that it is exclusively
based on accounting practices. It measures the quality of a firms accounting
practices, which is in some respects an output of its corporate governance
system, not a direct measure of it (Daines et al. 2010: 443).
Bhagat et al. (2008: 1853ff), in another rating the ratings paper, compare the
quality of different common CG measures by testing whether poor performance
leads to more CEO turnover in well governed firms. They find support for this
idea if CG is measured as the percentage of non-executive directors (NEDs) or
as the median dollar value of independent directors stockholdings. They also
investigate two widely-used academic measures, i.e. the G-Index developed by
Gompers et al. (2003) and Bebchuk et al.s (2009) E-Index (discussed in detail
below) and find support for the relationship between poor performance and
CEO turnover in well-governed firms. The most sophisticated measure they
use The Corporate Library measure , on the other hand, does not produce any
significant relationship. This leads them to conclude that simpler measure
outperform more complex ones.
These findings regarding the weak link between CG ratings and firm
performance is confirmed by the fact that a large number of studies, using
various measures and DVs, produce contradictory results. It goes beyond the
scope of this paper to review the financial economics literature that uses these
indicators to investigate the link between CG and performance (see Renders et
al. 2010 in particular for an overview of some). In this paper, I focus only on
studies which have explicitly the quality of CG rating methodologies as their
main topic, which I label the rating the ratings literature.
Different explanations exist for the absence of a robust empirical link between
corporate governance ratings and (future) performance. Thus, it might be that
different combinations of mechanisms are optimal for different firms and firms
chose what is optimal in their case. Alternatively, it is suggested that the
statistical methods used are not sophisticated enough (Daines et al. 2010: 440;
Renders et al. 2010: 87).
Contrary to what some authors suggest sometimes implicitly the absence of
predictive power of CG ratings regarding future performance does not
automatically imply that there is something wrong with the ratings. Indeed, it
might be that the theory that there is a link between CG and firm performance is
4
incorrect. However, Daines et al. (2010) provide evidence that there is indeed
something wrong with the ratings. They show that all but two ratings are very
weakly correlated, i.e. they assess the quality of the same firms corporate
governance system very differently. Thus, GMI and CGQ have a Pearson
correlation of .484 and a spearman correlation of .480, but all other pairs are
nearly uncorrelated (Daines et al. 2010: 444). Similarly, Brown and Caylor
(2006: footnote (FN) 3) find that their own governance measure (Gov-Score),
which is based on ISSs CGQ, only weakly correlates with Gompers et al.s
(2003) G-Index (Pearson correlation -.09 and Spearman -.10).5 In other words,
different methodologies seem to measure rather different things. This is a
surprising finding given that all four ratings claim to measure the same
underlying phenomenon, i.e. the quality of corporate governance.
Here, Daines et al. (2010: 46) suggest that the most likely explanation is simply
that corporate governance metrics are subject to serious measurement errors.
Two important sources of such errors, which are identified by virtually all
reviewing the reviews papers, are the kitchen-sink problem, whereby any
potentially relevant CG item is thrown into the index, and the tick-and-sum
problem, whereby the weighting (or absence thereof) of different variables of
the index are not theoretically justified. I now turn to discuss both problems in
turn.
The kitchen-sink problem
The weaknesses of CG indices are often attributed to their complexity and
unselective nature. Among academics, Gompers, Ishii & Metrick (GIM) (2003)
were among the first ones to suggest a measure for the quality of CG
governance based on a composite index. Their management entrenchment
index (the G-Index) used the Investor Responsibility Research Centre (IRRC)
data on anti-takeover provisions in companies charters (17 items in total) as
well as several other shareholder-relevant provisions. The indicator contains a
total of 24 items with higher scores indicating stronger management
entrenchment. It is hence hypothesised to correlate with worse performance.
They find support for this hypothesis in so far as the G-Index is significantly
related to stock returns and Tobins Q (but not to accounting performance).
Yet, Bebchuk, Cohen & Ferrel (BCF) (2009: 823) have criticised GIM and
cautioned against the kitchen sink approach of building ever-larger indexes of
governance measures. On the same grounds, they criticise the Institutional
Shareholder Services (ISS) Corporate Governance Quotient (CGQ), which
uses 61 variables and the Governance Metric International (GMI) measure that
uses more than 600 items.
BCFs re-analysis the G-index shows that only six of the 24 variables really
matter for firm valuation (measured as Tobins Q) and stockholder returns.
They group these variables in a new index called entrenchment index or Eindex.6 Their assessment of which ones of GIMs 24 variables matter is based
on a mix of criteria. Indeed, BCF (2009: 784) state that they have selected those
variables that are most strongly contested by institutional investors, because of
their negative impact on takeovers. The assessment of the contested nature of
these variables was confirmed by six expert interviews. Moreover, four of the
six are theoretically justified, because they constitute limitations on
shareholders voting power, which is according to BCF the shareholders
primary power. The E-index makes hence an important step in the right
direction by justifying at least a part of the variables included based on a
theoretical argument, i.e. an assumed hierarchy of shareholder rights, with
voting rights being considered more important than other rights (such as
presumably informational rights). Other than the reference to the importance
of voting rights there is no theoretical justification of the selection. At least one
of the six variables may have an ambiguous effect on shareholders wealth and
on entrenchment: Golden parachutes may facilitate takeovers rather than
prevent them (Bhagat et al. 2008:1821). The theoretical foundation for the
choices seems hence partial (what justifies the inclusion of two variables that
are not related to voting rights?) and one is hard pressed to avoid the conclusion
that the choice is ultimately based on what explains best the expected outcome.
The authors acknowledge that [t]o confirm that focusing on these provisions is
plausible, we also performed our own analysis of their consequences (Bebchuk
et al. 2009: 784). Indeed, the ultimate justification of the E-index is that it
produces unambiguous results, while the remaining G-index variables
(compiled in what they term the O-index) do not (Bebchuk et al. 2009: 822).
The six variables retained for the E-index are the ones - and indeed the only
ones of the 24 items of the G-index that are statistically significant when
regressed on Tobins Q and shareholder returns (cf. Bhagat et al. 2008: 1822).
Cremers and Nair (2005) were the first to explicitly criticise the composition of
the G- and E-Indices based on theoretical, rather than empirical grounds. They
observed that both the E- and the G-indices are almost exclusively composed of
variables pertaining to the ease with which a company can be taken over. They
suggest that any measure of CG needs to include besides this external
dimension of CG measures of the internal governance structure. Striving for
parsimony, Cremers and Nair (2005) reduce the E-index further and use only 3
anti-takeover variables (namely, staggered boards, restrictions of
shareholders ability to call a special meeting or to act by written consent and
blank check preferred stock). However, they add one variable shareholder
activism as a proxy for internal corporate governance mechanisms. Cremers
6
and Nair (2005) show that these four variables drive the association between
CG and performance.
Similarly, Brown and Caylor (2006) construct an indicator based on the idea
that indices should be as small as possible, but that they should still include
more than takeover defences.7 Contrary to GIM, BCF and Cremers and Nair
who all use IRRC data, Brown and Caylor (2006) use ISS data which contains
more than 60 items that relate not only to a companys external, but also to its
internal governance (board structure, compensation schemes etc.). They find
that compensation provisions and BoD characteristics matter more than antitakeover provisions. This observation is based on different statistical procedures
one of which is used by BCF as well that allow it to distinguish the variables
from the ISS data that actually drive the link with performance. They find that
seven variables matter and group them together in the so-called Gov-7 index.
Bhaghat et al. (2008) too use an empiricist approach to investigate what CG
variables really matter. However, Bhagat et al. (2008) go a step further than the
studies reviewed so far. Based on simultaneous equations systems, they find
three significant determinants of operating performance (Bhaghat 2008: 18481850): the separation of the CEO and Board Chairman role; the level of
independence of the BoD8; the strongest relationship they find relates to the
dollar value of the independent directors median shareholdings.
They too criticise existing approaches and CG indices, notably on grounds of
what they call two factually incorrect assumptions on which such indices are
based (Bhagat et al. 2008: 1808): firstly, that good governance components do
not vary across firms; secondly, that they are always complements and never
substitutes. They acknowledge hence the contextuality of CG bundles.
However, based on this analysis, they reach the rather radical conclusion that
composite measures are useless and that the enterprise of constructing reliable
composite measure should be abandoned. Instead of using an index, a single
variable should be used (Bhaghat et al. 2008: 1827).9 They see three distinct
advantages of such an approach (Bhaghat et al. 2008: 1833). First, using just
one variable reduces the probability of measurement errors (see a contrario
Larcker et al. 2007). Second, it constitutes a way around the critical problem of
weighting different items. Third, it avoids the thorny question of interaction
effects between different CG mechanisms (are they substitutes or
complements?). Avoiding the two latter problems is crucial according to them,
because we lack a theoretical model that would allow us to understand the
interaction between CG mechanisms (Bhaghat et al. 2008: 1834-5).
Besides striving for parsimony, these studies have in common that they rely on
a empirics-driven approach to the question of what should be included in an
index. In other words, while these are certainly positive theories in that they are
7
fully grounded in empirical evidence and fulfil criteria of scientific rigor (such
as falsifiability) (Donaldson 2012), their value as causal theories is limited.
Reducing the number of variables included in an indicator may increase
predictive power and avoid certain difficult choices that the construction of
more complex measures would force us to make. However, the pragmatic
approach is hardly satisfying from a theoretical standpoint. In particular,
oftentimes the reason why a given variable matters for a given outcome remains
obscure and theoretically unfounded. For instance, Bhagat et al.s (2008)
favourite measure seems plausible in that directors who have considerable
personal wealth tied to the companys fortunes will have incentives to monitor
managers closely. However, stating that directors want to monitor managers
does not explain why we should expect these directors to be able to achieve
efficient monitoring. Certain factors may indeed run counter their incentive
and/or ability to monitor managers effectively: they might not be truly
independent from the CEO, the CEO may also hold the positions of chairman of
the board and hence dominate the board, despite the BoD members inherent
interest in monitoring the CEO etc. Therefore, it would seem that focusing on
one single aspect of CG to predict outcomes may work in practice, but clearly
many important questions such as what corporate governance mechanisms
need to be present for directors to be able effectively to monitor CEOs?
remain unanswered and unanswerable.
In the worst case, such a pragmatic and empiricist approach leads to tautological
reasoning. Because CG is not theoretically conceptualised, but measured as an
empirically constructed set of practices that is defined by their positive impact
on performance, using such measures to answer the research question does CG
matter for firm performance? becomes tautological. 10 To be sure, if the only
goal is to predict future performance, then such a procedure may still be helpful.
Since Friedmans (1966[1953]) famous essay, the predictive power of a theory
has indeed oftentimes been taken as a reflection of its causal power without the
causal link between variables actually being explained. Consequently, all too
often, scholars use empirics merely to circumvent a theoretical void, failing thus
to contribute to the advancement of causal corporate governance theory.
Moreover, while the more parsimonious indicators may be empirically well
founded in that they drive performance they are statistically problematic due
to the pragmatic approach to index construction. Thus, the six variables of
BCFs (2005) E-index have only relatively low correlations (between 0.1 and
0.31). They argue however that this shows that each variable contributes
potentially a new aspect of corporate governance to the index. Similarly,
Bhaghat et al. (2008) observe that their privileged individual predictor of
performance (median outside director ownership) is only weakly correlated with
the Gompers et al. (2003) G-index. They suggest that a combined measure may
8
be the most powerful predictor of performance, because the two do not measure
the same dimensions (Bhaghat et al. 2008: 1851). This suggestion reflects the
dominant Friedmanian idea of the primacy of the predictive power of a model
over identifying, explaining and understanding causal links between different
CG mechanisms. However, methodologically, the combination of uncorrelated
variables into a single construct is highly questionable. Indeed, from a
methodological standpoint a main condition for a valid index is that the
variables included measure the same underlying factor and index construction
has been suggested in cases where the corporate governance variables present
high levels of multicollinearity (Rediker & Seth 1995: 98). One general
guideline is to include only variables with a Cronbachs alpha of at least 70%
(Cortina 1993).11
Besides the methodological problems with this approach, combining two
uncorrelated measures of CG (the G-index and director stock ownership), as
suggested by Bhagat et al. 2008, makes it virtually impossible to give the
construct any meaningful interpretation. If the G-index and the director
ownership variable are not correlated, how can we take them to measure the
same underlying construct, which is corporate governance?
Hence, attempts to reduce the number of variables by identifying which ones
matter most, have an important shortcoming, i.e. they do not provide any
theoretical insights into why certain variables matter for performance and others
not.
The check-and-sum problem
The problem of a lack of theory that could guide us in our choices regarding
what to include in an index and what not, is even more important regarding the
weighting of different variables once they are included. The above mentioned
papers by Bebchuk et al. (2009) and Brown and Caylor (2006) attempt to solve
the kitchen-sink problem by constructing indicators of the quality of corporate
governance that only contain relevant variables. However, they do not address
the second problem according to which corporate governance indices are
problematic (some say indeed nave, cf. Larcker et al. 2007: 964), because
they simply sum up different dimensions of corporate governance without any
theoretical justification of the equal weighting of each variable. Bhaghat et al.s
(2008) more radical solution, on the other hand, avoids the problem altogether
by suggesting the use of a single variable. Yet, this solution avoids the problem
rather than solving it.
There are few references to explicit weightings of different CG mechanisms
based on any conceptual or theoretical arguments. As mentioned above,
9
A fourth claim derived from the bundles perspective is that, CG practices vary
not only in terms of specific combinations that exist, but also in terms of the
intensity of these practices. This could be termed the degrees of
implementation claim. Thus, companies may choose only to partially enforce a
given CG mechanism, to comply only symbolically, or even to resist the
adoption of a legally/regulatory required practice (Aguilera et al. 2012). Thus,
two companies may have the same number of independent board members, but
the definition of independence may vary considerably between the two. 14 This
claim is not directly related to the idea of bundles, but derives from insights in
organisation studies regarding partial implementation of organisational
practices. However, it holds important lessons for the bundles approach as well,
because the actual effects of a given bundle may depend not just on
organisational and environmental contingencies, but also on the strength of the
different CG mechanisms that form a bundle themselves.
These four claims of the bundles approach, have far-reaching implications
for the notion of best practice in corporate governance. Indeed, whether a
given practice can be considered best practice may depend on the presence,
absence, or strength of another practice. The next section turns to explore what
implications this has for corporate governance indices and the definition of
good CG.
scores (cf. Fiss 2007). Also inductive research approaches, such as cluster- or
principal component analysis, can be used to identifying CG bundles (see
Jackson & Miyajima 2007b; Larcker et al. 2007). Finally, explicitly
configurational methods such as crisp set or fuzzy set qualitative comparative
analysis (QCA) constitute promising approaches to identify configurations of
CG mechanisms (Fiss 2007). All these methods of dealing with interaction
effects have advantages and shortcomings (cf. Fiss 2007 for a discussion).
Nevertheless, using any of these methods implies at the stage of data collection
and definition that the net should be cast wider rather than narrower when
measuring firm-level CG. In other words, we need to define measures that err
at least in a first step on the side of including too many items rather than too
few. This is in contradiction with the above-mentioned kitchen-sink criticism.
Secondly, a more theoretically grounded way of accounting for bundles is to
rely on different comparative- and country case studies that investigate CG
arrangements in detail. Indeed, studies on national corporate governance
systems have developed quite precise understandings of how different parts of a
corporate governance system relate to each other. While we may indeed lack a
universal, formal theory of how CG mechanisms relate to each other at the firm
level, there are studies about how different types of national CG systems work
and how their different dimensions (e.g. employee participation and finance)
relate to each other (cf. Weimar & Pappe 1999; Aoki & Jackson 2008; Gospel
& Pendelton 2003). Such studies can be used as mid-range theories or
heuristics, which allow us to identify important CG mechanisms a priori.
This will in turn allow researchers not only to decide which variables should be
included in a measure of CG practices, but also to hypothesise what interactions
may exist.
Such interactions are particularly well-research for the Anglo-Saxon
shareholder model of CG. It is generally accepted that the Anglo-Saxon model
relies on interactions between managerial incentive pay, oversight by
independent boards, the market for corporate control, high levels of
transparency in accounting and external auditing (Aoki & Jackson 2008, Hart
1995). Theoretically, this system is explained with reference to agency theory
(cf. Ward et al. 2009; Heinrich 2002, Harris & Raviv 2006, Hermalin &
Weisbach 1999). However, in other countries the precepts of agency theory may
be inaccurate for characterising actors behaviour (Lubatkin et al. 2005).
Nevertheless, the agency perspective has become the dominant approach, so
that the very definition of relevant corporate governance variables is usually
based on this perspective. The focus on the presence or absence of a market for
corporate control and anti-takeover measures for instance reflects this. Indeed,
these dimensions may be meaningless in other countries where the market for
corporate control is absent or plays a very different role than in the US (cf.
17
18
25
Notes
1
See Larcker et al. 2007 for a critique of some of the methodological solutions
that are suggested in the literature, notably the use of instrumental variables.
3
26
The six variables of the E-index are: i) staggered boards, ii) limits to
shareholder bylaw amendments, iii) poison pills, iv) golden parachutes, v)
supermajority requirements for mergers, vi) supermajority requirements for
charter amendments.
7
A similar point is made by Kogut (2012: 11) who criticises the existing CG
literature for equating good governance with ease by which the practices
permit the company to be taken over, which may partly explain why the link
between CG and firm value is elusvive: [D]uring acquisition waves, the
premium goes up, and during market turndowns, the premium goes down.
8
27
10
Among the few attempts to formalize CG theory are Harris & Raviv 2008,
Hermalin & Weisbach 1998 and Heinrich 2002.
13
14
28
17
29
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